Should commercial banks be prevented from creating money? Ben Dyson and Drew Jackson of Positive Money and Martin Wolf of the Financial Times argue that they should.
Here i argue that in board terms they are right but for the wrong reasons; there should be more government money created rather than bank credit money but the terms used often confusing and the reasons for using government money are some what different from those argued for. Furthermore, there are dangers both in the implementation of such a ban if the nature of money is not fully understood.
The Nature of Money
There are two main types of money as seen in modern economies: government created money and bank created money. Government created money includes banknotes and the reserves of commercial banks held at the central bank. The banknotes are used for small transactions, individuals whereas, reserves are used for settling transactions between commercial banks. Bank created money on the other hand is the money seen in individual and company bank accounts. This money is essentially a promise to pay, issued by the bank to the individual, and entitling the individual to demand government money (banknotes) on demand (demand deposits) or after some specified time period (time deposits).
In very simple terms there is very little government money in the bank backing up your commercial bank money. This leads to phenomena such as a “run on a bank” where depositors together demand to withdraw government money to the value of their bank account level. Unfortunately, a commercial bank does not hold government money to cover all the bank deposits and so banks typically have to close their doors and refuse to reimburse people.
Positive money, and the ‘Chicago plan’ before them proposes that bank accounts used for transactions should be 100% backed by government money. in this way, they would function like most people believe bank accounts function anyway: in other words, the government creates the money in individual bank accounts and they can withdraw it at any time.
There are a number of advantages of this plan, both real and perceived. Firstly, it will allow people’s bank accounts to be substantially less risky. Government money does not need to be backed by anything as it is the fundamental component of the system. So there is no need for detailed bank regulation as the security of individuals’ money would be guaranteed by design. On the other hand, there would be proper market discipline around the actions of banks because if they would need to borrow, they would also need to attract that money from investors. At present banks can simply issue money to fund their loans; in future they would need to issue bonds or attract investment funds in some other way.
This advantage also leads on to another namely that government would need to issue fewer bonds because a larger portion of their financing would be achieved with money issuance. Since money does not necessarily pay an interest rate this can be seen as eliminating the national debt (or a part of it). Indeed, the scale of private bank money issuance is currently similar to that of government debt issuance. It would be a welcome simplification if the government no longer needed to issue bonds, suffering occasional sovereign debt crises, and banks no longer needed to issue money, suffering occasional banking crises.
Lastly, its a simpler system in that money is created by the government in the way that most people believe it already is. Having control over the money supply, it is argued would lead to greater macroeconomic stability. In particular, money could be created in a counter cyclical way and could be directed to those sectors of the economy in need of expansion.
The problem with the way these proposals are expressed is that money is considered a simple and unitary concept. This is how it is perceived by the general public admittedly; money in a bank account can be used for purchasing goods and services in just the same way that bank notes can. However, the nature of that money is very different: One is an IOU from your bank, the other token or IOU (depending on your theory) from the Govt. But what is money and what isn’t money is not clear and is not easily legislated. In fact , current bank money was created to get around regulations banning commercial banks from issuing bank notes. If the emphasis of the proposal is on explicitly banning certain types of bank deposits, it is likely that banks will find other ways of getting around such legislation. This does not invalidate the advantage of the proposal but it does mean that you have to be very careful how legislation is framed. Furthermore, we can expect any legislation to provoke avoidance tactics which will mean the legislation has to be updated at a later date.
A related point is that what is important in bank money creation from a macroeconomic perspective is not the creation of money per se but rather the creation of credit. Just banning commercial (credit) bank money creation would leave untouched the question of the total amount of credit in the economy. Furthermore, it might not prevent the need for government intervention because very same dynamic processes associated with bank money creation (credit and asset price bubbles) can be financed by other financial instruments. In simple terms, current bank lending is often financed by the issuance of bank deposits but if this was banned it could be financed by issuance of securities which avoid being classified as money according to the regulations but in fact are fully liquid and redeemable at par (you get all your money back guaranteed). So macroeconomic policy would need to consider the total supply of credit not just the strict money supply according to some definition.